Option Pricing Followup Questions

Can you give me some very brief answers to my questions?

Option Pricing
- What is the law of one price?
- How do you determine lower and upper bounds?
- How do you use put-call parity?
- What is the binomial option-pricing model?
- How do you calculate option premiums using the binomial pricing model and put-call parity?

The Black-Scholes Option Pricing Model.
- What is the Black-Scholes option-pricing model?
- How do you apply the Black-Scholes option-pricing model?
- What is historical volatility?
- How do you find implied volatility?
- What is Merton's model?

Solution Preview

Hello!

- The Law of one price is an economic rule which states that in an efficient market, a security must have a single price, no matter how that security is created. For example, if an option can be created using two different sets of underlying securities, then the total price for each would be the same or else an arbitrage opportunity would exist.

- Upper bounds: in the case of a call option, it cannot be worth more than the stock price. If there is a violation of this rule, then arbitrageurs will enter and make a riskless profit by buying the stock and selling the call option. In the case of a put option, the upper bound is the strike price at which the contract has been entered. If this condition is violated then an investor can make use of the arbitrage opportunity by writing the option and investing the proceeds at the risk-free rate of interest.

- Lower bounds: the lower bound for a call option is the difference between the stock price and the discounted value of the strike price at the risk-free rate of interest. If the call price violates this rule, investors can arbitrage by buying the call option and selling the ...